How to Pay More Taxes
How to Pay More Taxes Before Year-End: A Strategic Move for Financial Planning
At first glance, the idea of paying more taxes might seem counterintuitive. After all, taxes are a significant expense for both individuals and businesses, and most seek to minimize them wherever possible. However, for certain taxpayers—especially business owners, investors, and high-income earners—paying more taxes before year-end can be a strategic decision that benefits them in the long run. Here’s how and why you might want to consider this unconventional approach to financial planning.
1. Accelerating Income
One common strategy to increase taxable income before the end of the year is to accelerate income into the current tax year. For individuals or businesses anticipating higher income in the following year, paying more taxes this year could save you from falling into a higher tax bracket in the future.
How to Accelerate Income:
Invoice Early: If you're a business owner, consider invoicing clients ahead of schedule to recognize the income in the current year.
Year-End Bonuses: If you're an employee or business owner, you might take a bonus before year-end rather than waiting until next year.
Sell Appreciated Assets: If you've held onto appreciated stocks or assets, consider selling them now to lock in gains and pay taxes on them at current rates.
2. Converting Retirement Accounts
If you're planning for retirement, converting a traditional IRA to a Roth IRA can trigger taxable income. Paying taxes now on the conversion allows you to enjoy tax-free growth and withdrawals later. This is particularly advantageous if you expect tax rates to increase in the future or if your income will be higher in retirement.
Benefits of a Roth Conversion:
Future withdrawals from a Roth IRA are tax-free, which can reduce your taxable income in retirement.
You can strategically time conversions to control the amount of tax you pay now, potentially staying within a lower tax bracket.
3. Taking Advantage of Tax Bracket Creep
Tax bracket creep occurs when inflation pushes your income into a higher tax bracket. Paying more taxes in the current year can help you stay in a lower bracket or avoid increased taxes from potential inflation-driven income growth.
If you’re on the edge of a tax bracket or subject to additional taxes like the Net Investment Income Tax (NIIT) or Alternative Minimum Tax (AMT), accelerating income or conversions can help you avoid future higher taxes due to bracket creep.
4. Maximizing Charitable Contributions
Charitable donations offer a two-fold benefit: they allow you to support causes you care about and reduce your taxable income through deductions. By front-loading charitable donations at the end of the year, you can lower your tax bill for the current year and plan for a larger deduction.
Strategies for Charitable Giving:
Donor-Advised Funds (DAFs): These allow you to make a large charitable contribution now and decide later which charities will benefit.
Bunching Deductions: If your itemized deductions are near the standard deduction threshold, you can "bunch" multiple years’ worth of charitable contributions into one year to maximize the tax benefits.
5. Prepaying Deductible Expenses
For taxpayers who itemize deductions, prepaying certain deductible expenses can increase your tax liability in the current year while lowering it in future years.
Common Prepaid Expenses:
Property Taxes: If you expect to be in a higher tax bracket in the future, consider prepaying property taxes for the next year.
Mortgage Interest: You may be able to prepay January’s mortgage interest before December 31 to claim the deduction on this year's tax return.
Business Expenses: Self-employed individuals or business owners can prepay for services or equipment to increase deductible expenses in the current year.
6. Planning for Capital Gains
If you’ve realized significant capital gains this year, you might consider taking additional gains before the end of the year. This approach is beneficial if tax rates on capital gains are expected to rise or if your income will be significantly higher in future years.
Additionally, consider the potential of harvesting gains, which involves selling investments that have appreciated and reinvesting the proceeds. This locks in the gains and allows you to pay taxes at the current lower rates rather than risking higher taxes later.
7. Paying State and Local Taxes Early
State and local tax (SALT) deductions are capped at $10,000, but if you haven't reached that cap, prepaying state income taxes can reduce your federal taxable income this year. While the SALT cap limits how much you can deduct, it’s still a valuable strategy for those who can take advantage of it.
Why Paying More Taxes Now Might Be Smart
While paying more taxes this year might feel painful, it can be a smart long-term strategy for several reasons:
Tax Rate Changes: Future tax rates may increase due to legislative changes or rising income. Paying taxes at today’s rates might save you from higher future rates.
Income Fluctuations: If your income fluctuates year to year, strategically paying more taxes now can help you avoid falling into a higher bracket later.
Financial Flexibility: By managing your tax liabilities, you can take control of your financial planning and retirement savings with more certainty.
Conclusion
Paying more taxes before year-end is not about being less tax-efficient; it's about being proactive with your financial planning. Accelerating income, managing deductions, and taking advantage of favorable tax rates now can help you build a more secure financial future. Always consult with a tax professional or financial advisor to ensure your year-end tax strategy aligns with your long-term financial goals.
